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As Piotr Łabuz—psychologist, trader, and financial mentor—explains: "Mental accounting is a mechanism through which we encode and control the sources of our income and the purposes for which we spend it." Depending on how we categorize a given earning or expense, we will manage our money differently. This is precisely why we are less careful when spending money received as a gift or won in a lottery compared to money earned through hard work. People who win huge sums in the lottery or inherit a fortune usually lose it quickly…
We turn out to be masters of "creative accounting"—especially on vacation. When on holiday, we are willing to pay significantly more for waffles, restaurants, or entertainment than we would ever accept in our hometown, because we categorize these as "vacation expenses" rather than "living expenses." This also applies to people who live in tourist destinations.
In the 1980s, American economist Richard Thaler described this phenomenon of "mental accounting," which contradicts the principles of classical economics and rational choice theory. According to Thaler, we create separate "mental accounts" in our minds—essentially drawers where we place specific expenses and income. We do this much like an accountant assigning various debits and credits to different ledgers. The goal of this mental "sorting" of money is to feel a greater sense of control over our finances and to manage different groups of expenses and income.
During financial coaching sessions, I work with clients not only on analyzing their expenses but also on their approach to money and the ways they perform mental accounting. To manage finances better, you need to change not just bad habits, but also your beliefs and way of thinking.
Mental accounting means that we can exhibit completely different approaches to money management in our private and professional lives, even though our personality, knowledge, and financial competence remain similar in both situations. Everyone likely knows people who manage their own funds very cautiously while spending company or public money with a light hand. It also happens that someone meticulously tracks their business expenses and income while completely ignoring their home budget.
Many psychological experiments have shown that our financial decisions are inconsistent. For example: if someone wants to go to the theater but loses a ticket that cost 100 PLN, they are unlikely to buy a new one because they will categorize that expense as "I have already consumed my entire theater budget for this month." At the same time, if they lose 100 PLN in cash, it will in no way reduce their willingness to spend that money on the theater, because the loss of the banknote was not categorized as "theater funds." They will take opposite actions, even though the loss was 100 PLN in both cases.
Clients in restaurants are often outraged when a 5% service charge is added to the bill, even if they always leave at least a 10% tip for the waiters themselves. However, in the first case, the 5% is categorized as a "forced surcharge," while in the second, it is seen as "my own desire to thank them for a good meal."
Mental accounting can be a trap and can lead to irrational decisions. This mechanism is used in sales and marketing. Advertisements and stores tempt us to perform a "mental reclassification" to entice us to shop. If we categorize expensive cosmetics under "I'm worth it" instead of "unnecessary luxury," we are more likely to make the purchase.
More serious financial consequences arise when many people, having 10,000 PLN in a savings account earning only 5% interest per year, simultaneously take out a short-term loan for 10,000 PLN, even though it carries a 15% annual interest rate. Logically, it would be much more profitable in this situation to withdraw the money from the low-interest savings account and avoid taking out the expensive loan!
Another example is the different approach many investors take toward spending profits from stocks. Winnett & Lewis (1995) noted that The propensity to consume gains is higher when receiving a dividend than when a stock price increases by an equivalent amount. Thus, investors treat gains received as dividends differently than gains resulting from stock price appreciation.[1]
It is worth mentioning two basic principles of mental accounting:
The principle of segregating gains
We derive more pleasure from many small gains/rewards than from one larger one. This means that you will usually feel more pleasure receiving two raises of 250 PLN each than one raise of 500 PLN. Similarly, going to a restaurant twice and paying 150 PLN each time will bring more satisfaction than going once and spending 300 PLN. This also applies to receiving gifts. Three small gifts will usually bring more joy than receiving one gift equal to the total value of the three. Children, in particular, will be happier with several cheaper toys than with one very expensive one. I wrote more about giving gifts in the article How to spend money to truly feel happy?
The principle of integrating losses
One large loss hurts less than several smaller losses. For example, one larger price increase will be easier for us to swallow than two smaller consecutive increases that add up to the same amount. And if we lose 5,000 PLN on the stock market at once, we will usually recover mentally faster than if we lose 2,500 PLN twice in a short period. With a one-time loss, it is easier to tell yourself that "it was just a one-off mistake" and maintain a sense of competence as an investor than if you made two bad bets on the stock market.
It happens that we mentally account for a gain as a loss and instead of joy, we feel bitterness! This happens when a boss promises us a 500 PLN raise but ultimately gives only 200 PLN. Even though we are earning 200 PLN more, we are more likely to feel offended than grateful. If, however, both the promise and the raise were for 200 PLN, we would feel satisfied. That is why it is better not to make over-the-top promises and instead pleasantly surprise someone with an extra bonus, a favor, or faster order fulfillment, rather than doing something that is still above the norm but below the promise.
Everyone falls victim to cognitive biases at times. We do not always make rational decisions. However, it is worth understanding what traps we fall into and why, and to be more aware of our own beliefs and thought patterns.
[1] "Mental Accounting and Its Consequences" Piotr Zielonka, https://skarbiec.biz/inne/home-klitomsl-public_html-121-skarbiec-wp-content-uploads-skarbiec-domy-maklerskie-mentalne-htm.html
